Conclusion: We want to be long markets where domestic consumption is trending up in light of a slowdown in global trade and Brazil is one of those economies.
Position: Long Brazilian equities via the etf EWZ.
On Wednesday, we bought Brazilian equities on sale with the Bovespa down 2.1% on the heels of negative data out of China affirming slowing demand. While it’s true that China is Brazil’s largest export market (18.5% in 2009), Brazil is much more defensive than consensus thinks.
To put things in perspective, the Bovespa is in the bottom fourth of performance for all major equity markets globally on a YTD basis (down just under 4%) – worse than both Mexico and Ireland. The Bovespa’s underperformance is due to a series of interest rate increases (from 8.75% to the current 10.75%), and weakness in Brazil’s main exports: copper (down -2% YTD), crude oil (down -4.6% YTD), soybeans (down -2% YTD), and sugar (-30 YTD). Moreover, the Bovespa index is dominated by Petrobras and Vale (a combined ~18-20% of market capitalization), so it’s no surprise that the Brazilian stock market trades similarly to crude oil and copper (both of which have been rocked on a weekly basis: down 7.6% and 2.1%, respectively).
We’ll leave consensus to wrestle with a two factor model, while we expand our analysis to determine the direction of Brazilian equities. Regarding foreign trade, Brazil’s economy is much more defensive than people think. Roughly 50% of Brazilian exports are commodities and basic materials, which can be interpreted in two ways. The first of which is that the short production chain on agricultural commodities limits any multiplier effect on the economy at large, which explains why despite YTD weakness in commodities, Brazilian unemployment is near all-time lows. Moreover, recent price appreciation in sugar and soybeans (up 11% and 8%, respectively on a monthly basis) is bullish for Brazil’s trade revenue.
Secondly, Brazilian trade revenue (~10% of GDP) is volatile and highly susceptible to swings in commodity prices. Furthermore Brazilian economists point out that Vale is the world’s largest producer of iron ore, which would imply that it could have a relative benefit in a time of industry consolidation. On Wednesday, we published a note highlighting the lack of Chinese demand for industrial commodities (iron ore, copper, crude oil, etc.) behind recent commodity REFLATION, which suggests that there is a substantial amount of downside risk that could weigh on commodity prices and Brazilian equities in the near term should this one-sided trade unwind in a meaningful way.
Despite this risk, we are comfortable holding the bag here on Brazilian equities for three main reasons: domestic consumption is trending up and looks to continue in that direction, inflation is trending down and should remain flat-to-slightly up from here, and interest rates hikes appear to be on hold for now.
On the consumption front, Brazil’s unemployment rate (7% in June) is just 20bps above all-time lows, which explains the recent strength in Brazilian retail sales. Brazil’s June retail sales came in yesterday at +11.3% Y/Y, up from 10.2% Y/Y in May and the 1% M/M increase far exceeded consensus expectations of a 0.3% gain. The 11.5% gain in 1H10 was the largest gain ever on a six-month basis. Furthermore, Brazilian companies have been taking advantage of the secular up-trend of Brazil’s middle class. Hypermarcas SA, Brazil’s fourth largest consumer goods company by market value, has spent $R787.6 million reais YTD on Brazilian consumer goods companies and has amassed an additional R$1.2 billion for more acquisitions in the next 12 to 18 months, citing rising employment and slowing inflation. On the inflation front, Brazil CPI has been headed in the right direction for the past three months, declining from the April high of 5.26% Y/Y to July’s 4.6 % Y/Y.
Regarding monetary policy, we are in line with market expectations for muted, if any, rate hikes throughout 2010, which is bullish on the margin for Brazilian growth. According to the most recent survey, SELIC rate projections came down for the third consecutive week, now at 11% by year end vs. an estimate of 11.5% last week, which is reflected in the currency market – the 3-month put/call spread for the Brazilian real is ~525bps, which is the most among 47 major currencies tracked by Bloomberg. The bond market is also expecting zero rate hikes throughout the year as yields on zero-coupon bonds due in 2012 fell to the lowest ever yesterday as the government sold 6.7 billion reais ($3.8 billion) of the securities in its biggest auction of a single maturity.
Weakening economic data also support this view: Brazil’s June industrial output fell the most in 18 months on a monthly basis, down 1.4% M/M (+12.4% Y/Y); Brazil’s service industry confidence fell for the fourth consecutive month in July to 129.5 vs. 131.5 in July. On the consumer front, select recent data has been worsening on the margin providing further downward pressure on interest rates: Brazilian consumer delinquencies have been on the uptrend, rising 1.5% M/M in July (+3.9% Y/Y) and Brazilian auto sales declined in June for the first time in 11 months on the heels of expiring government stimulus. All told, the combination of marginally weaker economic data and muted inflation will likely keep a lid on interest rates going forward, which is bullish for Brazilian growth and equities.
We do understand that owning Brazilian equities is quite contrarian here given all the noise coming down the pike regarding the elections and Petrobras’s share offering, both of which could be bearish on the margin for Brazilian equities over multiple durations. Petrobras, which was downgraded by UBS AG on Wednesday (after losing 25% of its market value YTD), is trading with an uncertainty premium in regards to the 5 billion barrels of oil it is seeking to purchase from the Brazilian government in exchange for stock. Investors are rightfully worried that a high price tag for the reserves (roughly $7.50 - $10 a barrel) will force the company to sell more shares to the public, which would result in incremental EPS dilution. Further complicating the situation are rumors from Societe Generale SA that Petrobras may delay the share offering again, citing a disagreement between the company and the National Petroleum Agency of Brazil on the price of the reserves. In no way is this a positive event for the Brazilian stock market, but as we pointed out earlier, Petrobras’ YTD decline suggests that a good chunk of this risk has been priced in. Furthermore, if the government agrees to sell the reserves at the low end of the range, Petrobras’ stock could surprise to the upside on the heels of that marginal tailwind.
Regarding the Brazilian elections, the current setup is less positive on the margin for Brazilian growth long term, though there is no shortage of near-term benefits should leading candidate Dilma Rousseff win the election. Rousseff, who is leading in the opinion polls (39% vs. 34% for Jose Serra) has raised more money than her opposition by a factor of 3x over Serra ($11.6 million reais). Unlike Serra, Rousseff has a reputation for relatively loose fiscal policy: as former head of the Government Accelerated Growth Progammes, she is linked to what will amount to over $500 billion – or ~33% of GDP – of infrastructure spending over the next five years. Money from the programs will continue to be a tailwind for the Brazilian economy over that duration, but longer term, investors fear that her heavy government hand will crowd out private sector investment – particularly if she is inclined to keep interest rates high to attract foreign capital to fund Brazilian government debt in order to finance increased deficit spending (3.4% of GDP currently). Although the construction jobs created by the current stimulus will not be around forever, we believe the growing Brazilian economy can withstand marginal deterioration of the government’s balance sheet over the next few years.